Tax 2010: Tax Give-Away Can Make Your Kids Rich

With record budget deficits, you can't exactly call Uncle Sam rich anymore. He may, in fact, be your poorest relative. But he's still giving away money hand over fist, often through a series of stealth tax breaks that most people have never even heard of.

One of these little-known breaks could greatly benefit your twenty-something kids, if they happen to have a job and you don't mind helping.

What is it and how can you use it to launch your kids on the road to wealth?

The break
You probably think you know all about retirement savings tax breaks, but chances are good that there's one you missed. It's called the "Savers Credit" and it can be used in conjunction with other retirement savings tax breaks to pay back -- in cold hard cash -- up to 60% of the amount a low-income filer saved in a qualified retirement plan.

Here's how it works: Sally Saver puts $2,000 in an IRA and deducts that amount from her taxable income. Because she doesn't earn a lot, she's in a low tax bracket. That means that the deduction she gets from contributing to a retirement plan doesn't save her much in tax dollars. (Deductions just reduce the amount of income subject to tax. When you're income is taxed at 10 cents on the dollar, a $1,000 deduction saves you just $100.)

In this case, Sally's IRA deduction saves her about $200 in federal income taxes. (If she pays state income taxes, it's likely to save a few bucks on her state return too.)

But there's more. If she's got a really limited income -- as your kids might when they're working at their first jobs -- she can qualify for the Savers Credit, which reduces her tax on a dollar-for-dollar basis for up to 50% of the amount she contributed. In this case, the credit pays her $1,000, which adds to the $200 she already saved. Her $2,000 contribution gets her a refund of $1,200 on her federal income taxes.

The catch
That's such a good deal, you know that there's gotta be a catch, right? There is.

The people who get the best tax break for savings can't afford to save. That's because single filers only get the 50% credit when they earn less than $16,750. The credit ratchets down for married couples after their joint income exceeds $33,500.

The credit doesn't phase out completely until single income exceeds $27,750 and married couples earn more than $55,500, but it drops to 20% of contributions and then to 10% before phasing out completely.

The game
So what good is a tax credit if you can't afford to take advantage of it? No good, unless you've got a parent or well-heeled relative who is willing to help you get started.

There's no law preventing your independent, working child from claiming the credit, even if you gave them the $2,000 to save. (You can give gifts worth up to $13,000 per beneficiary per year without any gift or income tax consequences.)

For the child to claim the credit, he or she must have earned at least the amount of the IRA deduction and they cannot be claimed or classified as a dependent.

Once you get the child started, he or she can presumably use that fat refund check to help fund the next year's retirement plan contribution. And if they're still in a low-enough tax bracket, Uncle Sam will reward them with another big credit the following year.

Saving on Last Year's taxesThe other nifty thing about this break is that you can contribute now and take the deduction and credit on your 2010 return. IRA contributions (Roth, traditional and SEP) can be made until the tax filing deadline, which is April 18th this year.

The final hook
It's important to mention that if you pull money out of retirement savings before retirement, you'll usually get hit with both taxes and penalties. That can be used as an argument not to save for retirement when you're young and have lots of other demands on your resources.

But it's exactly why saving young can make you rich. The power of compound interest is tremendous when you give it lots of time. If you get your 21-year-old saving for retirement at 21 and she puts in just $2,000 a year, every year, until she retires at age 67, she'll have $1.15 million at retirement. (This assumes an 8% average annual return, which is a conservative return assumption over long stretches for a diversified portfolio of stocks and bonds.)

In other words, she will retire a millionaire. And she will have saved just $92,000 of her own money.

If she waits until she's 31 -- and, by the way, now has a family and even more demands on her finances -- she'll contribute $20,000 less to savings, but have less than half as much at retirement. Her nest-egg would grow to just $488,513.